1. A Macroeconomic Theory of the Open Economy

2. Macroeconomic Variables in an Open Economy
An open economy is one that interacts freely with other economies around the world.
The important macroeconomic variables of an open economy include:
net exports (NX)
net capital outflow (NCO)
nominal exchange rates (e)
real exchange rates (eP/P*)
real interest rates (r)
Loanable funds (LF=I=S)
Theory helps us to link these variables together; however, to simplify the analysis we will make some assumptions.

3. Basic Assumptions
The model takes the economy’s GDP as given. Y = Y-bar (like the quantity theory)
The model takes the economy’s price level as given. P = P-bar (unlike the quantity theory)

4. The Theory of the Open Economy: A Complete Logical Flow
The theory relates and determines r, NCO, EP/P*, and NX
It begins with conditions in the loanable funds market and then the foreign exchange market.
In each market, the demand and supply are used, put together to determine equilibrium, and then the effects of shifts in demand and supply are analyzed.
The two markets are linked together and r, NCO, EP/P*, and NX are jointly determined.
Different policies and situations are then analyzed and their affect on r, NCO, EP/P*, and NX identified.

5. The Loanable Funds Market
The supply and demand in the loanable funds market determines the real interest rate {r}
Closed Economy: S=I only domestic borrowing and lending are allowed.
Open Economy: S=I+NCO this allows trade and borrowing and lending from the ROW (rest of the world)

6. SUPPLY AND DEMAND FOR LOANABLE FUNDS: OPEN ECONOMY
The Market for Loanable Funds
S = I + NCO
At the equilibrium interest rate, the amount that people want to save exactly balances the desired quantities of investment and net capital outflows.
The supply of loanable funds comes from national saving (S).
The demand for loanable funds comes from domestic investment (I) and net capital outflows (NCO).

7. The supply and demand for loanable funds depend on the real interest rate.
A higher real interest rate encourages people to save and raises the quantity of loanable funds supplied.
The interest rate adjusts to bring the supply and demand for loanable funds into balance
At the equilibrium interest rate, the amount that people want to save exactly balances the desired quantities of domestic investment and net foreign investment.

8. National Saving: S → SLF is positively related to r↓(↑) → SLF ↓(↑)
Investment and Net Capital Flow:
I+NCO → DLF is negatively related to
r ↓(↑) → DLF ↑(↓)
r ↓(↑) I ↑(↓)
r↓(↑) PV ↑(↓) of future returns
r ↓(↑) NCO ↑(↓)
rUS ↓(↑) US increases (decreases) demand for ROW assets and ROW decreases (increases) demand for US assets

9. Figure 3 How Net Capital Outflow Depends on the Interest Rate
Real
Interest
Rate
Net capital outflow
is negative.
Net capital outflow
is positive.
Net Capital
Outflow
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10. S↓ (income taxes↑ or budget →deficit), then r↑→LF↓
The equilibrium r in the LF market brings national saving = investment +net capital outflow or S=I+NCO.
Supply-side shocks to LF
S↓ (income taxes↑ or budget →deficit), then r↑→LF↓
S↑ (income taxes↓ or budget →surplus), then r↓→LF↑
Demand-side shocks to LF
I↑ (tax credits↑ or expected Y↑), then r↑→LF↑
I↓ (tax credits↓ or expected Y↓), then r↓→LF↓
NCO↓ (political instability abroad↑), then r↓→LF↓ [US holds fewer ROW assets and ROW holds more US assets]
NCO↑ (political stability abroad ↓), then r↑→LF↑ [US holds more ROW assets and ROW holds less US assets]
We have now fully described the LF market and the determination of r

11. Figure 1 The Market for Loanable Fund
Real
Interest
Rate
Supply of loanable funds
(from national saving)
Demand for loanable
funds (for domestic
investment and net
capital outflow)
Equilibrium
quantity
real interest
rate
Quantity of
Loanable Funds
Copyright©2003 Southwestern/Thomson Learning

12. The Market for Foreign-Currency Exchange
The two sides of the foreign-currency exchange market are represented by NCO and NX.
NCO represents the imbalance between the purchases and sales of capital assets.
NX represents the imbalance between exports and imports of goods and services.
In the market for foreign-currency exchange, U.S. dollars are traded for foreign currencies.
For an economy as a whole, NCO and NX must balance each other out, or:
NCO = NX

13. The Market for Foreign-Currency Exchange
The price that balances the supply and demand for foreign-currency is the real exchange rate.
The demand curve for dollars is downward sloping because a higher exchange rate makes domestic goods more expensive.
The supply curve is vertical because the quantity of dollars supplied for net capital outflow is unrelated to the real exchange rate. It is related to the real interest rate and comes from the loanable funds market.

14. The real exchange rate adjusts to balance the supply and demand for dollars.
At the equilibrium real exchange rate, the demand for dollars to buy net exports exactly balances the supply of dollars to be exchanged into foreign currency to buy assets abroad.
For example, if the US has a trade surplus, foreigners are demanding US dollars to buy the net exports. At the same time, US dollars are being supplied to buy the foreign assets from the resulting net capital outflow (US receipt of foreign assets).

15. The Foreign Exchange Market
The supply and demand in the foreign exchange market determines the real interest exchange rate EP/P*
Closed Economy: no trading, NX, or EP/P*.
Open Economy: NX=NCO this allows trade and borrowing and lending from the ROW (rest of the world)

16. Net Capital Outflow - NCO → S$
If NCO↑, US is supplying more dollars, on net, to purchase foreign assets
If NCO↓, US is supplying fewer dollars, on net, to purchase fewer foreign assets
NCO is determined by r in the loanable funds markets and is not related to EP/P*.
As EP/P*↓(↑), NCO remains the same ↓

17. Net Exports - NX → D$ is negatively related to EP/P*
If EP/P*↓, NX↑, D$↑ - US goods become cheaper, net exports increase, and ROW needs more US dollars to purchase more goods and services
If EP/P*↑, NX↓, D$↓ - US goods become more expensive, net exports decrease, and ROW needs fewer US dollars to purchase fewer goods and services
Equilibrium in the foreign exchange market occurs when the EP/P* equates the D$ with the S$ or NX=NCO .
Foreign Exchange Shocks
D$↑, S$ is constant from NCO, EP/P*↑, until quantity of D$↓ and equals the quantity of S$
D$↓, S$ is constant from NCO, EP/P*↓, until quantity of D$↑ and equals the quantity of S$

18. Figure 2 The Market for Foreign-Currency Exchange
Real
Exchange
Rate
Supply of dollars
(from net capital outflow)
Demand for dollars
(for net exports)
Equilibrium
quantity
real exchange
rate
Quantity of Dollars Exchanged
into Foreign Currency
Copyright©2003 Southwestern/Thomson Learning

19. EQUILIBRIUM IN THE OPEN ECONOMY
In the market for loanable funds, supply comes from national saving and demand comes from domestic investment and net capital outflow.
In the market for foreign-currency exchange, supply comes from net capital outflow and demand comes from net exports.
Net capital outflow links the loanable funds market and the foreign-currency exchange market.
The key determinant of net capital outflow is the real interest rate.

20. Prices in the loanable funds market and the foreign-currency exchange market adjust simultaneously to balance supply and demand in these two markets.
As they do, they determine the macroeconomic variables of national saving, domestic investment, net foreign investment, and net exports. WOW!
Second bullet: next to last line: net capital outflow

21. Linking the Loanable Funds and Foreign Exchange Market
NCO link the two markets together
Step 1: S=I+NCO or SLF=DLF →r
Step 2: r →NCO
Step 3: NCO →S$
Step 4: NX →D$
Step 5: D$=S$ →EP/P* and NX=NCO

22. Examples of Transmission of LF and FEM Shocks
Loanable Funds Shocks:
S↓, SLF↓, r↑,NCO↓,S$↓, EP/P*↑,NX↓
S↑, SLF↑, r↓,NCO↑,S$↑, EP/P*↓,NX↑
I↑, DLF↑, r↑,NCO↓,S$↓, EP/P*↑,NX↓
I↓, DLF↓, r↓,NCO↑,S$↑, EP/P*↓,NX↑
Foreign Exchange Shocks
D$↑, S$ is constant from NCO, EP/P*↑, until quantity of D$↓, but NX are constant, r is constant
D$↓, S$ is constant from NCO, EP/P*↓, until quantity of D$↑, but NX are constant, r is constant

23. Figure 4 The Real Equilibrium in an Open Economy
(a) The Market for Loanable Funds
(b) Net Capital Outflow
Real
Real
Interest
Interest
Net capital
outflow,
NCO
Supply
Rate
Rate
Demand r
Quantity of
Net Capital
Loanable Funds
Outflow
Real
Exchange
Supply
Rate
Demand E
Quantity of
Dollars
(c) The Market for Foreign-Currency Exchange
Copyright©2003 Southwestern/Thomson Learning

24. HOW POLICIES AND EVENTS AFFECT AN OPEN ECONOMY
The magnitude and variation in important macroeconomic variables depend on the following:
Government budget deficits
Trade policies
Political and economic stability

25. Government Budget Deficits
In an open economy, government budget deficits . . .
reduce the supply of loanable funds,
drive up the interest rate,
crowd out domestic investment,
cause net foreign investment to fall.
Last bullet: net capital outflow

26. Figure 5 The Effects of Government Budget Deficit
1. A budget deficit reduces
the supply of loanable funds . . .
(a) The Market for Loanable Funds
(b) Net Capital Outflow
Real
Real
Interest S S
Interest
Rate
Rate r2 B r2 E1 r A
which
increases
the real
interest
rate . . .
which in
turn reduces
net capital
outflow.
Demand
NCO
Quantity of
Net Capital
Loanable Funds
Outflow
Real
Exchange S S
Rate
4. The decrease
in net capital
outflow reduces
the supply of dollars
to be exchanged
into foreign
currency . . . E2
which
causes the
real exchange
rate to
appreciate.
Demand
Quantity of
Dollars
(c) The Market for Foreign-Currency Exchange
Copyright©2003 Southwestern/Thomson Learning

27. Effect of Budget Deficits on the Loanable Funds Market
A government budget deficit reduces national saving, which . . .
shifts the supply curve for loanable funds to the left, which . . .
raises interest rates
Effect of Budget Deficits on Net Foreign Investment
Higher interest rates reduce net foreign investment.
Effect on the Foreign-Currency Exchange Market
A decrease in net foreign investment reduces the supply of dollars to be exchanged into foreign currency.
This causes the real exchange rate to appreciate.

28. Trade Policy
A trade policy is a government policy that directly influences the quantity of goods and services that a country imports or exports.
Tariff: A tax on an imported good.
Import quota: A limit on the quantity of a good produced abroad and sold domestically.
Because they do not change national saving or domestic investment, trade policies do not affect the trade balance.
For a given level of national saving and domestic investment, the real exchange rate adjusts to keep the trade balance the same.
Trade policies have a greater effect on microeconomic than on macroeconomic markets.

29. Trade Policy Effect of an Import Quota
Because foreigners need dollars to buy U.S. net exports, there is an increased demand for dollars in the market for foreign-currency.
This leads to an appreciation of the real exchange rate.
There is no change in the interest rate because nothing happens in the loanable funds market.
There will be no change in net exports.
There is no change in net foreign investment even though an import quota reduces imports.

30. Effect of an Import Quota
An appreciation of the dollar in the foreign exchange market encourages imports and discourages exports.
This offsets the initial increase in net exports due to import quota.
Trade policies do not affect the trade balance.

31. Figure 6 The Effects of an Import Quota
(a) The Market for Loanable Funds
(b) Net Capital Outflow
Real
Real
Interest
Supply
Interest
Rate
Rate r r
3. Net exports,
however, remain
the same.
Demand
NCO
Quantity of
Net Capital
Loanable Funds
Outflow
Real
Exchange
Supply
Rate D
1. An import
quota increases
the demand for
dollars . . . E2
and
causes the
real exchange
rate to
appreciate. E D
Quantity of
Dollars
(c) The Market for Foreign-Currency Exchange
Copyright©2003 Southwestern/Thomson Learning

32. Political Instability and Capital Flight
Capital flight is a large and sudden reduction in the demand for assets located in a country.
Capital flight has its largest impact on the country from which the capital is fleeing, but it also affects other countries.
If investors become concerned about the safety of their investments, capital can quickly leave an economy.
Interest rates increase and the domestic currency depreciates.

33. This increased Mexican net capital outflow.
When investors around the world observed political problems in Mexico in 1994, they sold some of their Mexican assets and used the proceeds to buy assets of other countries.
This increased Mexican net capital outflow.
The demand for loanable funds in the loanable funds market increased, which increased the interest rate.
This increased the supply of pesos in the foreign-currency exchange market.

34. Figure 7 The Effects of Capital Flight
(a) The Market for Loanable Funds in Mexico
(b) Mexican Net Capital Outflow
Real
Real
Supply
NCO2
1. An increase
in net capital
outflow. . .
Interest
Interest
Rate D2
Rate r2
which
increases
the interest
rate. r1 r1
increases the demand
for loanable funds . . . D1
NCO1
Quantity of
Net Capital
Loanable Funds
Outflow
Real
Exchange S S2
Rate
4. At the same
time, the increase
in net capital
outflow
increases the
supply of pesos . . . E
which
causes the
peso to
depreciate. E
Demand
Quantity of
Pesos
(c) The Market for Foreign-Currency Exchange
Copyright©2003 Southwestern/Thomson Learning

35. Summary
To analyze the macroeconomics of open economies, two markets are central—the market for loanable funds and the market for foreign-currency exchange.
In the market for loanable funds, the interest rate adjusts to balance supply for loanable funds (from national saving) and demand for loanable funds (from domestic investment and net capital outflow).

36. Summary
In the market for foreign-currency exchange, the real exchange rate adjusts to balance the supply of dollars (for net capital outflow) and the demand for dollars (for net exports).
Net capital outflow is the variable that connects the two markets.

37. Summary
A policy that reduces national saving, such as a government budget deficit, reduces the supply of loanable funds and drives up the interest rate.
The higher interest rate reduces net capital outflow, reducing the supply of dollars.
The dollar appreciates, and net exports fall.

38. Summary
A trade restriction increases net exports and increases the demand for dollars in the market for foreign-currency exchange.
As a result, the dollar appreciates in value, making domestic goods more expensive relative to foreign goods.
This appreciation offsets the initial impact of the trade restrictions on net exports.

39. Summary
When investors change their attitudes about holding assets of a country, the ramifications for the country’s economy can be profound.
Political instability in a country can lead to capital flight.
Capital flight tends to increase interest rates and cause the country’s currency to depreciate.